How Would Proposed Tax On Stock Options Impact Twitter’s Cash Flows?
A new tax plan, which is yet to be passed in the Congress, is seeing significant pushback from startups and large tech companies alike. The tax reform, if passed, would require employees to pay tax on stock options at the time of vesting instead of paying tax when the options are exercised. Considering that stock-based compensation (SBC) is a significant part of employees’ overall compensation at startups and high-growth tech firms, this reform could lead employees to demand lower stock compensation in order to avoid the additional financial burden it would cause. As a result, startups and tech companies could eventually have to pay higher cash salaries in order to either make up for the additional taxes on employees’ income or reduce the SBC component. While a higher cash component in lieu of SBC wouldn’t impact a company’s earnings, it would have an on free cash flows.
To evaluate the impact of this reform, below we take a look at Twitter (NASDAQ:TWTR). Twitter’s stock-based compensation has accounted for around 20% of total revenues of late, but has accounted for as much as 90% of revenues in past years, as shown in the chart below:
Twitter’s Financial Performance
In 2016, Twitter generated $2.53 billion in revenues from advertising and licensing. Meanwhile, the free cash flow to the firm was around $400 million. We forecast that Twitter will continue to post positive free cash flows in the near foreseeable future, as indicated in the chart below:
What Happens If Tax Reform Is Passed?
If this tax reform were to pass in its current form (which we believe is unlikely), it could have a significant adverse impact on Twitter, as the company is increasing spending on sales and marketing (S&M) activity in pursuit of revenue growth. If the proposed tax reform is passed by the Congress, then Twitter may have to increase its cash compensation in lieu of SBC. If Twitter reduces its stock-based compensation in favor of cash, its cash flows will suffer. The charts below show what Twitter’s cash flows would look like if stock-based comp were reduced to 50% or 25% of its current value, with the balance paid in cash, as well as zero (which won’t happen, but is included for demonstrative purposes).
We believe Twitter’s long-term plan to make investments to pursue revenue growth could be jeopardized by this tax reform, as its cash flows would suffer substantially. If the company were to substitute its SBC with cash compensation, then its would likely report negative cash flows over the coming three years. After this time frame, its free cash flow would remain anemic at best.
You can modify our base case scenario here and come up with your own scenarios to assess the impact on Twitter’s cash flows due to the proposed tax reform. We currently have a $19 price estimate for Twitter’s stock, which is in line with the current market price.
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